Behavioral Mistakes and Biases in Investing
Behavioral Mistakes and Biases in Investing
In a previous article, I explored the value and benefits of using a professional financial planner rather than managing an investment portfolio on your own. Professional investors use a more sophisticated fund research and selection process, better re-balancing techniques, and tax loss harvesting methods to maximize return over time, as compared to the average investor. However, this month I don’t want to talk about the technical advantage possessed by professionals, I want to discuss the emotional side and decision-making errors that lead the average investor to under perform both the market and the average investment professional. Professional investors of course make mistakes, and are subject to the same biases as everyone else, but they tend to be more internally aware of them, which improves decision making on average.
It can be hard for many people to remove the emotional aspect of making investment and trading decisions. Numerous studies have shown that the majority of people under perform compared to professionals because of poor decision making and impulsivity. This effect is often a 1-2% difference, which can costs hundreds of thousands of dollars over a lifetime. A recent Vanguard study estimated up to a 3% potential difference, based primarily on the type of small adjustments professionals use that “do it yourselfers” don’t. The results of a study by Dalbar Inc showed that the average investor earns consistently below-average returns. For a twenty year period (1995-2015), the average stock investor earned a return of 5.19% compared to the S&P 500 average of 9.85% per year.
Common behavioral mistakes
So what are some of the common cognitive and emotional behaviors that lead to investment mistakes? One of the most common is simply overconfidence, with a dose of recency bias. Many studies have shown that investors put more money in when the market is going up, and pull money out when it’s going down. They view the stock market through a biased lens, where the most current events and trends are much more relevant than long-term or historic trends. The end result of investing this way is that you’re almost always buying high and selling low. That’s a great way to lose a lot of money. Related to overconfidence and recency bias is inflated self-confidence. Many people view themselves as smarter, more informed, and simply better than the average person. Unfortunately, the stock market has a way of humbling people with inflated self-confidence. In one notorious example, the brilliant mathematician Isaac Newton lost the equivalent of millions of dollars in 1720, by buying and selling stock in the South Sea Trading Company. He famously quipped after the loss that he “could calculate the motions of the heavenly bodies, but not the madness of the people”. As brilliant as Isaac Newton was, he was still subject to the same type of biases as everyone else.
Anchoring is a behavioral finance term that describes the common mistake of placing a psychological benchmark on a certain price, value, or return amount. For example, I often hear people say something similar to “well I lost 15%, but I’m going to hold until the price gets back to X, and I make my money back”. The stock market doesn’t care that you’ve lost 15% and there is no reason to think that stock is ever going to go back up, just because it went down. Three years ago, shares of General Electric were $32/share, and they’ve been heading down ever since. Currently, the share price is $9.46, but there are thousands of people still holding and waiting, very confident that somehow they will recoup their original investment. The “anchor point” in this example is the original price of GE in 2016. By psychologically committing to that anchor, these investors have lost over 70% of their original investment.
Another common mistake is herding. Herding is copying the behavior of others, even in the face of unfavorable outcomes. Simply put, herding is “crowd mentality”. It’s very easy for the average investor to be swept up into the euphoria of a stock or other asset that seemingly only goes up, and all of their friends and family are participating in this great new thing that’s going to revolutionize the world. But unfortunately, most of the time, when the larger “crowd” has heard of the investment and its being touted by media outlets like CNN Money and Fox Business, its already too late. A good example of this would be the cryptocurrency craze that reached its peak in late 2017 and early 2018. Everyone was pouring money into Bitcoin, Ripple, and Ethereum, even people that tend to avoid investing, or those that tend to be risk averse. It just seemed like they only went up. In this case, the wisdom of the herd proved wrong, as the price of bitcoin and other cryptocurrencies was down over 70% in 2018.
The last mistake I want to mention is very simple. It’s panicking. More specifically, panic selling. Most people cannot bear to watch their money evaporate into thin air, and will quickly pull their money into cash or safer investments in the wake of a market crash or recession. This is a mistake, and generally leads to buying high and selling low. Nobody can predict the top and bottom of market swings, and it’s a fool’s errand to try and do so. Most investors would do far better to invest heavily into weakness. I was once speaking to a friend, who by all accounts is an extremely intelligent person in every aspect of his life, but was still subject to the same biases as everyone else. He proudly declared to me that he sold all his stock and “went to cash” shortly after the initial market crash in 2008, and then invested back into the market in 2011. To him, this was a huge victory. However, by the end of 2011, the market had nearly doubled in value from its low point in 2008, and he missed out on nearly $50,000 worth of dividends and interest payments in those three years. The overall “cost” of this mistake was hundreds of thousands of dollars. Doing nothing was by far the best course of action.
How do you avoid these mistakes and biases?
Use a financial planner to help guide your investments and your thinking on investing. Financial planners act as behavioral coaches and encourage people to not panic at the wrong times, to stick to their investment plans, and help their clients deal with the emotional aspects of losing money.
Understand your risk tolerance. Not everyone can handle the swings that come with being 100% invested in stock. Use bonds, treasuries, and real estate. Diversify and maintain a portfolio that makes you comfortable, and won’t have you panic when things go south.
Stop micromanaging and do nothing. Good long-term investing involves your long-term goals, so why are you looking at your investments on a daily basis? The more decisions you make, the worse the result will be. I advocate looking at you investments only once every few months, and let your financial planner handle the details. Micromanaging leads to poor decision making, impulsivity, and ultimately panic.
Be disciplined. You’ve spent the time to make a financial plan and evaluate your long-term goals. Stick to your plan and see it through. If you have a 20-year financial plan, you need to give it time to develop.
Ignore your friends and family. This might be my most controversial suggestion, but generally it’s not a good idea to take advice on investing from other people. They don’t understand your goals, risk tolerance, and time horizon. Even worse, they might be relying on media hype to make decisions, and that ultimately can lead to very poor results.